The Business Counselor Blog™

February 2010 Gutterman Law & Business Newsletter

The Gutterman Law & Business February 2010 Newsletter is now available.  For further information please visit the GL&B website.

New Year Plans for the Business Counselor Blog

First of all, best wishes to all of you for 2010 and thank you for visiting and viewing the Business Counselor Blog.  My January 2010 Newsletter for Gutterman Law & Business includes an updated professional summary for me as well as lists of my publications and the 2009 blog postings for this Blog and the Emerging Companies Blog.  I hope you will find this resource helpful and please visit my website at www.alangutterman.com for more information.

This year I'm going to be changing the update schedule for this Blog to include one monthly posting--generally near the end of each month--that includes materials from all of the publications that I have been working on over the weeks leading up to the post.  In addition, I will provide shorter posts as the need arises based on things that I see or hear that might be of interest and value to you.

News You Can Use 12.10.07

In a previous post I described a proposed new rule promulgated by the U.S. Immigration and Customs Enforcement (“ICE”) that would have mandated the steps that must be taken by employers within a specified time period in the event that the employer received a social security no-match letter (commonly referred to as a “mismatch letter”) from either the Social Security Administration (“SSA”) or the Department of Homeland Security (“DHS”).  The rule, which was to go into effect on September 14, 2007, was seen by many as the first sign that the federal government intends to begin taking stronger enforcement measures against employers that hire undocumented immigrant workers and it was reported that the SSA was poised to send letters to about 140,000 employers with at least 10 workers whose names and social security numbers did not match.  However, as reported in another previous post, a federal judge in San Francisco, responding to criticisms from groups such as the AFL-CIO and the American Civil Liberties Union, who argued that the new rule would lead to discrimination against documented and US citizen workers and would ultimately lead to unfair employment terminations, issuing a preliminary injunction forbidding dispatch of the letters based on the grounds that the new rules contravene the governing statute, are arbitrary and capricious under the Administrative Procedure Act, were an exercise of ultra vires authority by the regulatory agencies, and were promulgated in violation of the Regulatory Flexibility Act.  Now the Bush Administration has announced that it intended to appeal the issuance of the preliminary injunction while simultaneously working on drafting a revised rule that it believes will address all of the concerns raised by the judge.  It is expected that the revised rule will be issued in late March of 2008 and will include, among other things, a survey of the impact of the rule on small business that the judge said should have been completed when the original version of the new rule was issued.

News You Can Use 12.03.07

In a previous post I discussed a series of new rules promulgated by the U.S. Patent Office that were to go into effect as of November 1, 2007 and which promised to implement several drastic changes in the process for filing and prosecuting patent applications in the United States.  Responding to a number of lingering concerns raised throughout the industry, a U.S. District Court issued a Temporary Restraining Order ("TRO") on October 31, 2007 halting implementation of the new rules.  Among the issues that remain to be resolved is how the new rule would impact patent applications that are currently pending; how the new rules would be implemented in practice, given that many felt that the guidance issued by the USPTO was vague and ambiguous; and whether the rulemaking exceeded the authority of the USPTO and contradicted the statutory language of the patent laws.  Further court proceedings will follow to determine whether or not a permanent injunction should be entered that would prevent the USPTO from implementing and enforcing the new rules as they are currently written.

News You Can Use 11.26.07

I have previously posted details regarding certain proposals that the Securities and Exchange Commission has been considering that would have a substantial impact on capital-raising, reporting and disclosure requirements for smaller companies. The SEC finally acted on November 15, 2007 to unanimous approve three measures that would:

• Make scaled disclosure regulations available to an additional 1,500 smaller companies;
  Shorten the holding periods under Securities Act Rule 144 for restricted securities of public companies from one year to six months to reduce the cost of capital and to increase access to capital; and
• Create two new exemptions for compensatory employee stock options so that the Exchange Act registration requirements will not be triggered solely by a company's compensation decisions.

Specifically, smaller reporting companies will enjoy the benefits of the following amendments to reduce and simplify their reporting obligations:

• Replacement of the current "small business issuer" category with a new expanded category of "smaller reporting companies" having less than $75 million in public equity float or, if a company does not have a calculable public equity float, having revenues of less than $50 million in the last fiscal year;
• Expanded eligibility for the Commission's scaled disclosure and reporting requirements for smaller companies by allowing the newly defined category of smaller reporting companies to use the scaled disclosure requirements;
• Movement of 12 non-financial scaled disclosure item requirements from Regulation S-B into Regulation S-K (the scaled disclosure requirements will only be available to smaller reporting companies);
• Movement of the scaled financial statement requirements in Item 310 of Regulation S-B into new Article 8 of Regulation S-X, and amend these requirements to provide a scaled disclosure option for smaller reporting companies, requiring two years of balance sheet data instead of one year;
• Permitting smaller reporting companies to elect to comply with scaled financial disclosure and non-financial disclosure on an item-by-item or "a la carte" basis;
• Elimination of the current "SB" forms, but allowing a phase-out period for current small business issuers transitioning to smaller reporting company status; and
• Permitting all foreign companies to qualify as "smaller reporting companies" if they choose to file on domestic company forms and provide financial statements prepared in accordance with U.S.Generally Accepted Accounting Principles.

The effective date for these rules will be 30 days after their publication in the Federal Register.

The SEC also confirmed previously announced revisions to Securities Act Rule 144, including the following:

• Shortening the holding period for restricted securities of reporting companies to six months;
• Substantially simplifying compliance for non-affiliates by allowing non-affiliates of reporting companies to freely resell restricted securities after satisfying a six-month holding period (subject only to the Rule 144(c) public information requirement until the securities have been held for one year) and by allowing non-affiliates of non-reporting companies to freely resell restricted securities after satisfying a 12-month holding period;
• For affiliates' sales under Rule 144, revising the manner of sale requirements for equity securities and eliminate them for debt securities and relax the volume limitations for debt securities;
  For affiliates' sales, raise the thresholds that trigger Form 144 filing requirements from 500 shares or $10,000 to 5,000 shares or $50,000;
• Simplifying and streamlining the Preliminary Note to and other parts of Rule 144; and
  codifying certain staff interpretations relating to Rule 144.

Securities Act Rule 145 is also being amended to eliminate the presumptive underwriter provision except with respect to transactions involving blank check or shell companies; and revise the resale provisions of Rule 145(d).

These amendments will be effective 60 days after their publication in the Federal Register.

Finally, Exchange Act Rule 12h-1 is being amended to provide an exemption for private non-reporting issuers from Exchange Act Section 12(g) registration for compensatory employee stock options issued under employee stock option plans; and provide an exemption for issuers that are required to file reports under the Exchange Act pursuant to Exchange Act Section 13 or Section 15(d) from Section 12(g) registration for compensatory employee stock options. The exemptions will apply only to an issuer's compensatory employee stock options and will not extend to the class of securities underlying those options.  These amendments will be effective as soon as they are published in the Federal Register.

News You Can Use 11.19.07

A revised version of “I-9 Form, Employment Eligibility Verification” was issued by the USCIS on November 7, 2007 and employers are being urged to begin using the new form (dated June 5, 2007) immediately even though use is not yet mandatory until the Federal Register publication requirements have been satisfied.  The biggest change in the new form was elimination of the following five documents that were previously included on List A as satisfactory proof of both the identify of the employee and the employee’s eligibility for employment:

• Certificate of U.S.Citizenship (Form N-560 or N-570)
• Certificate of Naturalization (Form N-550 or N-570)
• Alien Registration Receipt Card (Form I-151 - the current I-551 Permanent Resident Card stays on List A)
• Reentry Permit (Form I-327)
• Refugee Travel Document (Form I-571)

The USCIS eliminated these documents from List A because it believes that they were too susceptible to counterfeiting and fraud; however, employers need not take any action to re-verify I-9 forms based on a previous presentation and use of these documents.  The USCIS also added an unexpired employment authorization document (I-688, I-688A, I-688B and I-766) to List A.

Further information on using and completing the new I-9 form, including updated examples of completed forms, can be found in the Handbook for Employers, Instructions for Completing the Form I-9.

News You Can Use 11.12.07

Even if the Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”) ultimately approve a proposed acquisition that is subject to review under the Hart-Scott-Rodino Act (“HSR Act”), the parties to the transaction must comply with the applicable disclosure requirements on a timely basis or risk having substantial fines assessed by the regulators. In addition to making a pre-closing filing with the DOJ and the FTC whenever the transaction-size requirements of the HSR Act are triggered and observing the applicable waiting period before closing, the parties must also submit any so-called “Item 4(c) documents,” which include all documents that may have been prepared in connection with the proposed transaction that address any aspect of competition, sales growth, or entry into new product or geographic markets if seen by an officer or director.   Among other things, parties may be required to submit documents prepared by third parties (e.g., a report from an investment bank), formal internal presentations made to directors when the board authorized the proposed transaction, e-mails and even handwritten notes.  In one case earlier this year, Iconix Brand Group was fined $550,000 for failing to submit Item 4(c) documents that were uncovered during an investigation that was launched after the transaction was approved because regulators were puzzled by the fact that no documents had been submitted, even though the FTC specifically asked about them after the HSR filing was first received, for a transaction that required in excess of $200 million in outside financing.  Once documents were submitted in response to a civil investigative demand (“CID”) issued to Iconix by the DOJ, the DOJ concluded that the HSR Act had been violated and that fines should begin to accrue from the date of closing at the rate of $11,000 for each day of the violation.  In its press release, the DOJ made it clear that it will vigorously enforce filing requirements even if it concludes that a transaction poses no threat to competition or consumers.  It should be noted that individual officers and directors of the company are also subject to fine for any failure to comply with the Item 4(c) document requirements.

News You Can Use 10.22.07

House Version of New Patent Act Approved

On September 7, 2007, the House of Representatives approved its version of the proposed new Patent Reform Act of 2007 (H.R. 1908).  The most important provision in H.R. 1908, which is also included in companion Senate bill still under consideration by that body (S. 1145), is the change of the US patent system to a first-to-file system; however, H.R. 1908 conditions this change upon adoption of a grace period by major patent authorities around the world while S. 1145 does not have a similar condition.  The next step toward adoption of comprehensive patent reform is formal Senate action on S. 1145.  While the bill was passed out of the Judiciary Committee in July and the Senate Majority Leader placed it on the calendar of bills that are likely to be acted upon in October, a number of Senators have placed a “hold” on the bill that may delay action.  When and if the Senate passes S. 1145 further work will be needed to reconcile differences between the House and Senate versions.  Further details of the new Act can be found in a previous post.

Temporary Injunction on Social Security “No Match” Regulations Extended

In a previous post I discussed the proposed implementation of new Department of Homeland Security (“DHS”) rules regarding how employers would be required to respond to Social Security “no match” letters.  The DHS and the Social Security Administration (“SSA”) were poised to send an initial batch of letters to some 140,000 employers pointing out Social Security Number (“SSN”) discrepancies for as many as 8 million employees.  However, opponents of the new rules have successfully convinced a US District Judge in Northern California to issue a preliminary injunction forbidden dispatch of the letters based on the grounds that the new rules contravene the governing statute, are arbitrary and capricious under the Administrative Procedure Act, are an exercise of ultra vires authority by the regulatory agencies, and were promulgated in violation of the Regulatory Flexibility Act.  The judge noted that “the effects of the rule’s implementation will be severe” and that the letter would include lawfully employed individuals and thus “would result in irreparable harm to innocent workers and employees.”   The injunction will remain in effect until the court makes a final decision on the legality of the new rules. It is expected that the regulatory agencies will appeal the issuance of the injunction; however, it is unlikely that the appeal will be heard before the end of this year.  While the injunction puts a halt to the dissemination of the 140,000 letters it does not mean that employers should ignore “no match” letters.  The new rules clearly reflect a dramatic change in governmental policy on what constitutes a “reasonable” response by employers to the news that there is a SSN discrepancy with one or more of their employees and the only question at this point is whether the rules will have the force of law as a regulation or be implemented as an important factor in prosecutorial discretion as to whether a particular employer is more likely to be subject to investigation and prosecution for knowingly employing an unauthorized worker.

News You Can Use 10.15.07

Drafting Enforceable No-Hire Clauses

A supplier of services may seek protection against the customer attempting to hire the supplier’s employees to render services similar to those provided under the agreement.  One method that has often been used in drafting these so-called “no-hire” provisions is to attempt to prohibit the customer from hiring any employee of the supplier for a specified period of time following termination of the agreement.  However, there is a strong likelihood that such a broad restriction would not be enforced by the courts and suppliers are best advised to seek a more reasonable restriction that would apply only to those employees of a supplier who actually provided services under the agreement and was limited to active solicitation of such employees.

In VL Systems, Inc. v. Unisen, Inc., the California Court of Appeal considered the legality and enforceability of a no-hire provision in a short-term consulting contract which provided that the customer could not hire any employee of the supplier for 12 months after the termination of the contract, subject to a liquidated damages provision.  Within the 12-month period after the contract ended the customer did hire an employee of the supplier; however, the employee had never performed any work for the customer nor had the employee been employed by the supplier during the term of the consulting contract.  While the district court awarded the specified liquidated damages to the supplier based on a finding that the customer breached the contract, the Court of Appeal reversed and declared the no-hire provision to be unenforceable as a matter of law.  The Court of Appeal discussed the question of whether two parties can agree on a no-hire provision as a matter of contract and, while recognizing that freedom of contract was an important principle, determined that the broad no-hire provision in the particular contract could not be enforced due to the potentially serious impact that it might have on the rights of a broad range of third parties, particularly those persons who were not even employed by the supplier during the period that it was performing services for the customer.  The Court of Appeal commented that the particular provision was unnecessary to protect the legitimate interests of the supplier and clearly outweighed by the long-standing public policy in favor of employee mobility established by California Business & Professions Code § 16600.

The Court of Appeal in VL Systems did distinguish another case involving a no-hire provision in a contract where the plaintiff-supplier was a physician placement agency that provided labor, including physicians, to hospitals in the same way as a temporary agency.  In that situation, the supplier was allowed to enforce a no-hire provision in a contract with a hospital that was limited to the employees provided by the plaintiff who actually performed work for the hospital. In addition, the liquidated damages clause in the contract that applied upon violation of the no-hire provision was found to be “fair and reasonable” given that it was based on a reasonable assessment of the actual damages that the supplier suffered when the contract was terminated prior to the hospital’s employment of one of the supplier’s employees.

While the decision of the Court of Appeal in VL Systems makes it clear that suppliers cannot expect to enforce no-hire provisions that cover employees of the supplier that did not provide services to the customer and/or employees hired by the supplier after the contract with the customer ended, the Court of Appeal carefully noted that its decision was limited to the particular facts and that a "more narrowly drawn clause limited to soliciting employees who had actually performed work for the client might pass muster."  Even in that situation, however, it is recommended that supplier’s include a specific sum for liquidated damages that is based on a good faith and verifiable estimate of the reasonable value of supplier’s time and costs associated with the recruitment and training of the employees that are covered by the no-hire provision.

News You Can Use 10.08.07

A Parent Corporation May Be Liable for a Breach of a Subsidiary’s Contract. 

Servo Kinetics, Inc. (“SKI”), Tokyo Precision Instruments Co. Ltd. (“TSS”) and its parent, Moog, Inc. (“Moog”) were all involved in the business of servo valves.  A servo valve is an electro-hydraulically controlled mechanism used in such products as flight simulators.  SKI repairs and rebuilds servo valves, and distributes servo valves in North America, frequently under its own name, but does not produce servo valves.  TSS and SKI had engaged in a business relationship since 1990, whereby SKI distributed TSS manufactured servo valves in North America.  According to SKI, SKI never dealt with another servo valve manufacturer.Moog is a large international manufacturer and distributor of servo valves, operating in multiple regions of the world, including North America, through its subsidiaries.  Prior to Moog’s acquisition of TSS, Moog servo valves were a substitute for TSS servo valves, and the companies competed for customers.  Prior to the acquisition, TSS and SKI operated under exclusive distribution agreements lasting one year, which were renewed automatically unless the other party gave notice to the contrary.  In January 2002, under the specter of Moog buying TSS, SKI and TSS sought to execute an agreement that would last for a longer duration (hereinafter, the “Agreement”).  The Agreement was dated February 8, 2002, and provided that SKI would be the exclusive distributor of TSS servo valves in North and South America for a five-year period, with an automatic renewal for an additional year unless either party gave written notice to the contrary.

On February 28, 2002, Moog signed an agreement to purchase TSS by acquiring TSS stock and the deal closed on March 29, 2002.  On April 8, 2002, TSS sent a letter to SKI providing notice that it was terminating the Agreement with SKI in six months, which termination was in violation of the Agreement.  The relationship between TSS and SKI deteriorated in the period following TSS’s notice of termination.  During that same period, Moog made drastic changes to TSS.  These changes amounted to shutting down TSS’s operations as an independent entity, integrating some components of TSS’s business into Moog’s, and selling the other components.

On August 4, 2003, SKI filed suit against Moog and TSS alleging breach of contract against TSS and Moog as well as tortious interference with a contract against Moog, among other claims.  Moog removed the action to the United States District Court for the Eastern District of Michigan.  The district court granted summary judgment in favor of Moog and TSS on all claims.  SKI then appealed the district court’s grant of summary judgment.  On appeal to the Sixth Circuit Court of Appeals, SKI argued that:  (i) TSS breached its contract with SKI; (ii) Moog was liable for TSS’s breach of contract under a veil-piercing theory; and (iii) Moog was liable for tortuous interference with the contract between TSS and SKI.  The breach of contract claim was governed by Japanese law; the other claims were governed by Michigan law. Under Michigan law, there is a presumption that the corporate form will be respected.  This presumption, often called the “corporate veil,” may be pierced only where an otherwise separate corporate existence has been used to subvert justice or cause a result that is contrary to some overriding public policy.

Michigan courts will not pierce the corporate veil unless:  (i) the corporate entity was a mere instrumentality of another entity or individual; (ii) the corporate entity was used to commit a fraud or wrong; and (ii) the plaintiff suffered an unjust loss.  Turning to the first element, the court concluded that a reasonable jury could find that TSS was a mere instrumentality of Moog.  TSS’s factory was sold, the majority of TSS’s employees were laid off and those that were not were integrated into Moog, and TSS’s customers were transferred to Moog.  Additionally, the court held that the fact that TSS directors consisted entirely of Moog employees was undeniably insufficient, ipso facto, to disregard the corporate form, but that such facts supported the conclusion that TSS was a mere instrumentality of Moog.  The court summarily found that the other two elements of the test had been satisfied.

With regard to the tortuous interference claim, the court stated that under Michigan law, tortuous interference with contract requires:  (i) a contract; (ii) a breach; and (iii) instigation of the breach without justification by a third party.  Here, the court concluded that because there was a significant unity of interest between a TSS and its sole shareholder Moog that Moog could not be considered a sufficient third party capable of interfering with its own subsidiary’s contracts necessary to satisfy such a claim.  The opinion of the court can be found at Servo Kinetics, Inc. v. Tokyo Precision Instruments Co. Ltd., 475 F.3d 783 (6^th Cir. 2007).

Corporations Seeking to Modify Consumer Contracts Should Provide Actual Notice to Consumers

Joe Douglas contracted for long distance telephone service with America Online (“AOL”).  Talk America subsequently acquired this business from AOL and continued to provide the service to AOL’s former customers.  Talk Americaadded four provisions to the service contract: (1) additional service charges; (2) a class action waiver; (3) an arbitration clause; and (4) a choice-of-law provision pointing to New York law.  Talk America posted the revised contract on its website, but Douglas claimed it never notified him of the changes.  Meanwhile, Douglas continued to use Talk America’s services for four years.

After becoming aware of the changes, Douglas filed a class action lawsuit in federal district court charging violations of the Federal Communications Act, breach of contract and violations of various California consumer protection statutes.  Talk America sought enforcement of the arbitration provision of the revised contract.  The district court found the notice provided to be sufficient and issued an order compelling arbitration of Douglas ’ claims.  Because no decision was reached on the merits of his claims, Douglas could not appeal.  Douglas sued the district court seeking a Writ of Mandamus (court order instructing the district court to proceed with a trial on the claims). To render a decision on such a procedural instruction, the Ninth Circuit Court of Appeals considered whether the modification of Douglas’ contract was enforceable such that a class-action waiver and arbitration clause enjoined Douglas’ claims. Talk  America attempted to amend its service contracts by posting the new contract on its website where it was visible to customers who paid their bills online.  The Ninth Circuit found that the district court assumed that Douglas visited the website when the district court said that the contract was available on “the web site on which Plaintiff paid his bills.”  The Ninth Circuit noted that Douglas had originally authorized AOL to automatically charge his credit card for the services he received and that Talk America continued that practice.  Because of this practice, Douglas had no reason to visit Talk America’s website to pay his bills.  Furthermore, the Ninth Circuit found that even if Douglas had visited the website, a mere posting of a new contract was not sufficient notice.  Customers, like Douglas, would have no reason to look at the contract posted there because “[p]arties to a contract have no obligation to check the terms on a periodic basis to learn whether they have been changed by the other side.”

In finding this attempted modification unenforceable, the Ninth Circuit referenced several fundamental contract principles including: (1) a party can’t unilaterally change the terms of a contract; a party must obtain the other party’s consent before doing so because a revised contract is merely an offer and does not bind the parties until it is accepted; and (2) an offeree cannot actually assent to an offer unless he knows of its existence.  The Ninth Circuit added that even if Douglas' continued use of Talk America 's service could be considered assent, such assent can only be inferred after he received proper notice of the proposed changes. Douglas claimed that no such notice was given.

The Ninth Circuit contrasted this case with the cases cited by the district court,  Crawford v.Talk America, Inc., 2005 U.S. Dist. LEXIS 23181 (S.D. Ill. Oct. 6, 2005) and Bischoff v. DirecTV, Inc., 180 F. Supp. 2d 1097 (C.D. Cal. 2002).  The customers in these cases each received notice of a modified contract by mail.  The service provider in Bischoff mailed the contract to the customer; the service provider in Crawford gave  notice to the customer that she could see the contract terms online or call the service provider to learn of the terms.  Additionally, the customers in both cases were new to the service and would be on notice that assent to contract terms was required for using the service.  The Ninth Circuit also noted that the California Court of Appeal has held that a revised contract containing an arbitration clause is unenforceable against existing customers, even when they are given notice by mail.  Badie v. Bank of Am., 67 Cal.App. 4th 779, 801 (Ct. App. 1998). The Ninth Circuit held that the district court’s error reflected fundamental misapplications of contract law and granted the petition ordering the class action claim heard based on the original contract. Douglas provides that the first priority for modifying this type of contract is adequate notice to the customer.  This notice requirement is as important to contract modifications as it is to initial contract formation.  In addition to being notified “of” contract changes, a Douglas footnote likely also requires that the notice must tell exactly “how” the contract has changed or otherwise clearly communicate what the modification does.  Otherwise, the consumer must consider each version side-by-side to locate the changes.  The opinion of the court can be found at Douglas v. United States Dist. Court for the Cent. Dist. of Cal., 495 F.3d 1062 (9th Cir. 2007).

While posting a modified contract on the website alone, absent adequate notice to the customer, may render the modifications unenforceable, communicating the details of modifications by posting on a corporate website is acceptable.  In Briceno v. Sprint Spectrum, 911 So. 2d 176 (Fla. Dist. Ct. App.2005), the company mailed a general notice with a monthly bill that the contract had changed.  Although the notice did not communicate the specific changes, it directed customers to a website where the changes—an arbitration clause in Briceno—were detailed.  Although not requiring how notice of contract modifications should be communicated, when Douglas is read in light of Briceno, companies must provide the customer with adequate notice and the means to discover the precise contract terms that have changed.  Following adequate notice, cases like Crawford and Bischoff suggest that assent in the form of continued use of the services by the customer renders the modifications enforceable.